The terms Exchange Traded Fund (ETF) and Exchange-Traded Product (ETP)
might seem interchangeable, they actually represent distinct categories of
investment instruments, each with its unique characteristics, advantages,
and considerations. While these instruments are traded on an exchange and
provide exposure to shares and other assets such as indices and
commodities, there are a few important differences in terms of complexity
and risk.
ETPs are a broader category that encompasses a number of investment
instruments. The ETPs cover a wider range of products such as ETFs,
Exchange Traded Notes (ETNs), and Exchange Traded Commodities (ETCs).
Therefore, ETFs are a subset of ETPs.
ETPs are best defined as open-ended investments listed on the exchange and
traded and settled like shares. Open-ended means that the number of units
on issue can increase or decrease in response to demand and supply. ETPs are
passive investments aiming to replicate the performance of a given market,
generally by tracking an underlying benchmark index and usually trading at
or close to net asset value (NAV).
Exchange Traded Funds
ETFs are open-ended funds that track an underlying index, commodity, or a
basket of assets and are regulated in Europe under UCITS (Undertakings for
Collective Investment in Transferable Securities). ETFs offer the
diversification benefits of mutual funds with the added advantage of
real-time trading on stock exchanges. They are generally considered to be
lower risk due to its diversification and asset backing.
In order to achieve their investment objectives, ETF providers can either
use physical or synthetic replication. Physical replication can be achieved
either through full replication or optimised sampling. When using synthetic
replication, ETF providers enter into a swap agreement with single or
multiple counterparties. Synthetic replication generally reduces costs and
tracking error but increases counterparty risk.
Exchange Traded Commodities/Currencies
ETCs are similar to ETFs and offer the same advantages; however, they track
the performance of a single commodity or a basket of commodities. In order
to achieve their investment objectives ETCs either use a physical/spot
approach or futures contracts. Unlike ETFs, in Europe ETNs are not
regulated under UCITS, which makes them somewhat less stringent in
compliance.
The main difference between ETFs and ETCs is that the later are debt
securities instead of funds. The debt instruments are underwritten by a
bank for the issuer of the ETC and the commodities tracked by the ETC serve
as collateral for the note.
The capital invested in an ETC is not a fund asset which is protected in
case of insolvency of the issuer. Commodity ETFs invest directly in and hold
physical commodities, while ETCs don’t buy or sell the commodity or futures
contract directly. The assets of the ETCs are a debenture issued by a bank,
collateralized by the commodity the ETC tracks.
ETC are generally riskier than ETFs due to potential counterparty/issuer
risk.
Exchange Traded Notes
ETNs are generally senior, unsecured, unsubordinated debt issued by a
financial institution and listed on the exchange. They are not asset-backed
but are supported by the creditworthiness of the issuing institution,
therefore, adding credit risk. The underwriting bank agrees to pay an index
return, minus fees. ETCs are not subject to UCITS and do not have to comply
with its diversification requirements. These products are generally riskier
than ETFs and ETCs due to the credit risk and lack of asset backing.
There are two types of ETNs: namely collateralised and uncollateralised
notes. Collateralised ETNs are hedged partly or fully against counterparty
risk whereas uncollateralised ETNs are fully exposed to counterparty risk.
Investors should therefore make sure they fully understand the underlying
risk of the ETN before investing.
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